Financial Statement Analysis

Ratio Analysis

5 categories of ratios:

1.) Liquidity ratios, which give an idea of the firm’s ability to pay off debts that are maturing within
a year.
 A liquid asset is one that trades in an active market and thus can be quickly converted to
cash at the going market price
 Current Ratio
o This ratio is calculated by dividing current assets by current liabilities. It
indicates the extent to which current liabilities are covered by those assets
expected to be converted to cash in the near future.

o (if < industry’s average = liquidity position is

weak)
 Quick (Acid Test) Ratio
o This ratio is calculated by deducting inventories from current assets and then
dividing the remainder by current liabilities. measures the firm’s ability to pay
off short-term obligations without relying on the sale of inventories, is
important

o
2.) Asset management ratios, which give an idea of how efficiently the firm is using its assets.
 Inventory Turnover Ratio
o This ratio is calculated by dividing sales by inventories. It indicates how many
times inventory is turned over during the year

o
 Days Sales Outstanding (DSO) Ratio
o This ratio is calculated by dividing accounts receivable by average sales per day.
It indicates the average length of time the firm must wait after making a sale
before it receives cash.

o (if > Industry’s ave. =

customers are not paying their bills on time on average.
 Fixed Assets Turnover Ratio
o The ratio of sales to net fixed assets. It measures how effectively the firm uses
its plant and equipment.

o
 Total Assets Turnover Ratio
 o This ratio is calculated by dividing sales by total assets. It measures how
effectively the firm uses its total assets

o (<industry’s average = it is not generating

enough sales given its total assets)
3.) Debt management ratios, which give an idea of how the firm has financed its assets as well as
the firm’s ability to repay its long-term debt.
 Total Debt to Total Capital (debt ratio)
o The ratio of total debt to total capital; it measures the percentage of the firm’s
capital provided by debtholders

o
 Times-Interest Earned (TIE) Ratio
o The ratio of earnings before interest and taxes (EBIT) to interest charges; a
measure of the firm’s ability to meet its annual interest payments.

o
4.) Profitability ratios, which give an idea of how profitably the firm is operating and utilizing its
assets.
 Operating Margin
o This ratio measures operating income, or EBIT, per dollar of sales; it is calculated
by dividing operating income

o
 Profit Margin
o This ratio measures net income per dollar of sales and is calculated by dividing
net income by sales.

o
 Return on Total Assets (ROA)
o The ratio of net income to total assets; it measures the rate of return on the
firm’s assets.

o
 Return on Common Equity (ROE)
o The ratio of net income to common equity; it measures the rate of return on
common stockholders’ investment.

o
 Return on Invested Capital (ROIC)
o The ratio of after-tax operating income to total invested capital; it measures the
total return that the company has provided for its investors.
 o


 Basic Earning Power (BEP) Ratio
o This ratio indicates the ability of the firm’s assets to generate operating income;
it is calculated by dividing EBIT by total assets.

o
5.) Market value ratios, which give an idea of what investors think about the firm and its future
prospects
 Price/Earnings (P/E) Ratio
o The ratio of the price per share to earnings per share; shows the dollar amount
investors will pay for $1 of current earnings

o
 Market/Book (M/B) Ratio The ratio of a stock’s market price to its book value

o
 o

 Enterprise Value/ EBITDA (EV/EBITDA) Ratio

o The ratio of a firm’s enterprise value relative to its EBITDA.

o
o Then apply EV/ EBITDA. (< Industry’s ave. = firm has inefficient operations)

DuPont Equation A formula that shows that the rate of return on equity can be found as the product of
profit margin, total assets turnover, and the equity multiplier. It shows the relationships among asset
management, debt management, and profitability ratios

3 approaches to assess performance using financial ratios

1. Industry Average
2. Benchmarking (out)– The process of comparing a particular company with a subset of top
competitors in its industry. (comparing a particular ratio of different companies)
3. Trend Analysis (within) – an analysis of a firm’s financial ratios over time; used to estimate the
likelihood of improvement or deterioration in its financial condition.
Exercises

4-1 DAYS SALES OUTSTANDING Baxley Brothers has a DSO of 23 days, and its annual sales are
$3,650,000. What is its accounts receivable balance? Assume that it uses a 365-day year.
AR= $230,000

4-2 DEBT TO CAPITAL RATIO Kaye’s Kitchenware has a market/book ratio equal to 1. Its stock price is
$12 per share and it has 4.8 million shares outstanding. The firm’s total capital is $110 million and it
finances with only debt and common equity. What is its debt-to-capital ratio?
47.63%

4-3 DuPONT ANALYSIS Henderson’s Hardware has an ROA of 11%, a 6% profit margin, and an ROE of
23%. What is its total assets turnover? What is its equity multiplier? 2.09x
 4-4 MARKET/BOOK AND EV/EBITDA RATIOS Edelman Engines has $17 billion in total assets —of which
cash and equivalents total $100 million. Its balance sheet shows $1.7 billion in current liabilities—of
which the notes payable balance totals $1 billion. The firm also has $10.2 billion in long-term debt and
$5.1 billion in common equity. It has 300 million shares of common stock outstanding, and its stock price
is $20 per share. The firm’s EBITDA totals $1.368 billion. Assume the firm’s debt is priced at par, so the
market value of its debt equals its book value. What are Edelman’s market/book and its EV/EBITDA
ratios? Market/Book = 1.18x, EV/EBITDA =12.5x

4-5 PRICE/EARNINGS RATIO A company has an EPS of $2.40, a book value per share of $21.84, and a
market/book ratio of 2.73. What is its P/E ratio? 24.57

4-6 DuPONT AND ROE A firm has a profit margin of 3% and an equity multiplier of 1.9. Its sales are $150
million, and it has total assets of $60 million. What is its ROE? 14.25%

4-7 ROE AND ROIC Baker Industries’ net income is $24,000, its interest expense is $5,000, and its tax
rate is 40%. Its notes payable equals $27,000, long-term debt equals $75,000, and common equity
equals $250,000. The firm finances with only debt and common equity, so it has no preferred stock.
What are the firm’s ROE and ROIC? ROE = 9.6%, ROIC = 7.67%

4-8 DuPONT AND NET INCOME Precious Metal Mining has $17 million in sales, its ROE is 17%, and its
total assets turnover is 3.23. Common equity on the firm’s balance sheet is 50% of its total assets. What
is its net income 451,562.50

4-9 BEP, ROE, AND ROIC Broward Manufacturing recently reported the following information:

Net income $615,000

ROA 10% Interest expense $202,950

Accounts payable and accruals $950,000

Broward’s tax rate is 30%.

Broward finances with only debt and common equity, so it has no preferred stock. 40% of its total
invested capital is debt, and 60% of its total invested capital is common equity. Calculate its basic
earning power (BEP), its return on equity (ROE), and its return on invested capital (ROIC).
BEP = 17.59%, ROE= 19.71%, ROIC = 14.56%

4-10 M/B, SHARE PRICE , AND EV/EBITDA You are given the following information: Stockholders’ equity
as reported on the firm’s balance sheet 5 $6.5 billion, price ∕ earnings ratio 5 9, common shares
outstanding 5 180 million, and market/book ratio 5 2.0. The firm’s market value of total debt is $7
billion, the firm has cash and equivalents totaling $250 million, and the firm’s EBITDA equals $2 billion.
What is the price of a share of the company’s common stock? ₱72.22 What is the firm’s EV/EBITDA? =
9.875

4-11 RATIO CALCULATIONS Assume the following relationships for the Caulder Corp.:
Sales/Total assets 1.33

Return on assets (ROA) 4.0%

Return on equity (ROE) 8.0%

Calculate Caulder’s profit margin and debt-to-capital ratio assuming the firm uses only debt and
common equity, so total assets equal total invested capital.

Profit Margin = 3.08%, Debt to capital ratio = 50%

4-12 RATIO CALCULATIONS Thomson Trucking has $16 billion in assets, and its tax rate is 40%. Its basic
earning power (BEP) ratio is 10%, and its return on assets (ROA) is 5%. What is its times-interest-earned
(TIE) ratio? 5.999X ~ 6X

4-13 TIE AND ROIC RATIOS The W.C. Pruett Corp. has $600,000 of interest-bearing debt outstanding,
and it pays an annual interest rate of 7%. In addition, it has $600,000 of common stock on its balance
sheet. It finances with only debt and common equity, so it has no preferred stock. Its annual sales are
$2.7 million, its average tax rate is 35%, and its profit margin is 7%. What are its TIE ratio and its return
on invested capital (ROIC)? 7.92x, 18.03%

4-14 RETURN ON EQUITY Pacific Packaging’s ROE last year was only 5%, but its management has
developed a new operating plan that calls for a debt-to-capital ratio of 40%, which will result in annual
interest charges of $561,000. The firm has no plans to use preferred stock and total assets equal total
invested capital. Management projects an EBIT of $1,258,000 on sales of $17,000,000, and it expects to
have a total assets turnover ratio of 2.1. Under these conditions, the tax rate will be 35%. If the changes
are made, what will be the company’s return on equity? 9.33%

4-15 RETURN ON EQUITY AND QUICK RATIO Lloyd Inc. has sales of $200,000, a net income of 15,000,
and the following balance sheet:

The new owner thinks that inventories are excessive and can be lowered to the point where the current
ratio is equal to the industry average, 2.53, without affecting sales or net income. If inventories are sold
and not replaced (thus reducing the current ratio to 2.53), if the funds generated are used to reduce
common equity (stock can be repurchased at book value), and if no other changes occur, by how much
will the ROE change? 5.54% increase What will be the firm’s new quick ratio? 1.2x
4-16 RETURN ON EQUITY Commonwealth Construction (CC) needs $3 million of assets to get started,
and it expects to have a basic earning power ratio of 35%. CC will own no securities, all of its income will
be operating income. If it so chooses, CC can finance up to 30% of its assets with debt, which will have
an 8% interest rate. If it chooses to use debt, the firm will finance using only debt and common equity,
so no preferred stock will be used. Assuming a 40% tax rate on taxable income, what is the difference
between CC’s expected ROE if it finances these assets with 30% debt versus its expected ROE if it
finances these assets entirely with common stock? 6.94%

4-17 CONCEPTUAL: RETURN ON EQUITY Which of the following statements is most correct? (Hint: Work
Problem 4-16 before answering 4-17, and consider the solution setup for 4-16 as you think about 4-17.)
a. If a firm’s expected basic earning power (BEP) is constant for all of its assets and exceeds the interest
rate on its debt, adding assets and financing them with debt will raise the firm’s expected return on
common equity (ROE).

b. The higher a firm’s tax rate, the lower its BEP ratio, other things held constant.

c. The higher the interest rate on a firm’s debt, the lower its BEP ratio, other things held constant.

d. The higher a firm’s debt ratio, the lower its BEP ratio, other things held constant.

e. Statement a is false, but statements b, c, and d are true.

Statement A

4-18 TIE RATIO MPI Incorporated has $6 billion in assets, and its tax rate is 35%. Its basic earning power
(BEP) ratio is 11%, and its return on assets (ROA) is 6%. What is MPI’s timesinterest-earned (TIE) ratio?
6.22×

4-19 CURRENT RATIO The Stewart Company has $2,392,500 in current assets and $1,076,625 in current
liabilities. Its initial inventory level is $526,350, and it will raise funds as additional notes payable and use
them to increase inventory. How much can its short-term debt (notes payable) increase without pushing
its current ratio below 2.0? $239,250

4-20 DSO AND ACCOUNTS RECEIVABLE Ingraham Inc. currently has $205,000 in accounts receivable,
and its days sales outstanding (DSO) is 71 days. It wants to reduce its DSO to 20 days by pressuring more
of its customers to pay their bills on time. If this policy is adopted, the company’s average sales will fall
by 15%. What will be the level of accounts receivable following the change? Assume a 365-day year.
$49,084.51
4-22 balance sheet analysis

4-24 A firm has been experiencing low profitability in recent years. Perform an analysis of the firm’s
financial position using the DuPont equation. The firm has no lease payments but has a $2 million sinking
fund payment on its debt. The most recent industry average ratios and the firm’s financial statements are
as follows:

Req. A
Calculate the ratios that would be useful in this analysis
Req. B
Construct a DuPont equation, and compare the company’s ratios to the industry average
ratios.
 Req. C - Do the balance sheet accounts or the income statement figures seem to be
primarily responsible for the low profits?
If we take a look at the firm’s ratios compared to its industry ratios. We can see that the
income statement as represented by the profit margin at 3.4% compares favorably with the
industry average. Even so, the total assets turnover ratio, fixed assets turnover ratio,
inventory turnover, ROE, and ROA, are noticeably far below the average. This concludes
that the balance sheet accounts are responsible for the poor performance of the firm.
We can conclude that the firm’s ROA is lower than the industry’s ROA because the
company's assets are too large compared to its net income. If we relate this to the firm's
turnover ratios, the company seems to be inefficient in managing its assets, having far below
than the industry turnover ratios and also having obsolete assets.

Req. D - Which specific accounts seem to be most out of line relative to other firms in the
industry?
Req. E - If the firm had a pronounced seasonal sales pattern or if it grew rapidly during the year, how
might that affect the validity of your ratio analysis? How might you correct for such potential problems?

FINANCIAL PLANNING AND FORECASTING

Mission Statement A condensed version of a firm’s strategic plan.

Corporate Scope Defines a firm’s lines of business and geographic areas of operation.

Statement of Corporate Objectives Sets forth specific goals to guide management.

Corporate Strategies Broad approaches developed for achieving a firm’s goals

Operating Plan Provides management detailed implementation guidance, based on the corporate
strategy, to help meet the corporate objectives.

Financial Plan The document that includes assumptions, projected financial statements, and projected
ratios and ties the entire planning process together.

 Here are a firm’s primary capital sources:

 o Spontaneously Generated Funds Funds that arise out of normal business operations
from its suppliers, employees, and the government (such as accounts payable and
accrued wages and taxes) that reduce the firm’s need for external financing.
o Retention Ratio It is the proportion of net income that is reinvested in the firm, and is
calculated as 1 minus the dividend payout ratio.
o Additional Funds Needed (AFN) The amount of external capital (interest-bearing debt
and preferred and common stock) that will be necessary to acquire the required assets.
 AFN Equation An equation that shows the relationship of external funds needed by a firm to its
projected increase in assets, the spontaneous increase in liabilities, and its increase in retained
earnings.

o
o Sustainable Growth Rate The maximum achievable growth rate without the firm having
to raise external funds. In other words, it is the growth rate at which the firm’s AFN
equals zero.
o Capital Intensity Ratio The ratio of assets required per dollar of sales (A0 *S0 ).
o Excess Capacity Adjustments Changes made to the existing asset forecast because the
firm is not operating at full capacity.

o
o Forecasted Financial Statements Financial statements that project the company’s
financial position and performance over a period of years.

Regression Analysis A statistical technique that fits a line to observed data points so that the resulting
equation can be used to forecast other data points

This chapter described techniques for forecasting financial statements, which is a crucial part of the
financial planning process. Both investors and corporations regularly use forecasting techniques to help
value a company’s stock, to estimate the benefits of potential projects, and to estimate how changes in
capital structure, dividend policy, and working capital policy influence shareholder value.

The type of forecasting described in this chapter is important for several reasons. First, if the
projected operating results are unsatisfactory, management can “go back to the drawing board,”
reformulate its plans, and develop more reasonable targets for the coming year. Second, the funds
required to meet the sales forecast simply may not be obtainable. If not, it is obviously better to know
this in advance and to scale back projected operations than to suddenly run out of cash and have
operations grind to an abrupt halt. And third, firms often give guidance to analysts regarding likely
future earnings, so it is beneficial to be able to provide reasonably accurate forecasts

Exercise

17-1 AFN EQUATION Carlsbad Corporation’s sales are expected to increase from $5 million in 2018 to $6
million in 2019, or by 20%. Its assets totaled $3 million at the end of 2018. Carlsbad is at full capacity, so
its assets must grow in proportion to projected sales. At the end of 2018, current liabilities are $1
million, consisting of $250,000 of accounts payable, $500,000 of notes payable, and $250,000 of accrued
liabilities. Its profit margin is forecasted to be 3%, and the forecasted retention ratio is 30%. Use the AFN
equation to forecast the additional funds Carlsbad will need for the coming year. $446,000

17-2 AFN EQUATION Refer to problem 17-1. What additional funds would be needed if the company’s
year-end 2018 assets had been $4 million? Assume that all other numbers are the same. Why is this AFN
different from the one you found in problem 17-1? Is the company’s “capital intensity” the same or
different? Explain. $646,000. The AFN is higher because the given asset is higher in this problem.
The capital intensity is different. The firm is more capital intensive since it would require a large
increase in assets to support the increase in sales.

17-3 AFN EQUATION Refer to problem 17-1 and assume that the company had $3 million in assets at
the end of 2018. However, now assume that the company pays no dividends. Under these assumptions,
what additional funds would be needed for the coming year? Why is this AFN different from the one you
found in problem 17-1? 320,000

17-4 PRO FORMA INCOME STATEMENT Austin Grocers recently reported the following 2018 income
statement (in millions of dollars)
For the coming year, the company is forecasting a 25% increase in sales, and it expects that its year-end
operating costs, including depreciation, will equal 70% of sales. Austin’s tax rate, interest expense, and
dividend payout ratio are all expected to remain constant.

a. What is Austin’s projected 2019 net income? 133,500,000

b. What is the expected growth rate in Austin’s dividends? 39%

17-5 EXCESS CAPACITY Williamson Industries has $7 billion in sales and $1.944 billion in fixed assets.
Currently, the company’s fixed assets are operating at 90% of capacity.

a. What level of sales could Williamson Industries have obtained if it had been operating at full capacity?

b. What is Williamson’s target fixed assets/sales ratio?

c. If Williamson’s sales increase 15%, how large of an increase in fixed assets will the company need to
meet its target fixed assets/sales ratio?

17-6 REGRESSION AND INVENTORIES Jasper Furnishings has $300 million in sales. The company expects
that its sales will increase 12% this year. Jasper’s CFO uses a simple linear regression to forecast the
company’s inventory level for a given level of projected sales. On the basis of recent history, the
estimated relationship between inventories and sales (in millions of dollars) is as follows:

Inventories 5 $25 1 0.125(Sales)

Given the estimated sales forecast and the estimated relationship between inventories and sales, what
are your forecasts of the company’s year-end inventory level and its inventory turnover ratio
17-7 PRO FORMA INCOME STATEMENT At the end of last year, Roberts Inc. reported the following
income statement (in millions of dollars):

Looking ahead to the following year, the company’s CFO has assembled this information:

● Year-end sales are expected to be 10% higher than the $3 billion in sales generated last year.

● Year-end operating costs, excluding depreciation, are expected to equal 80% of yearend sales.

● Depreciation is expected to increase at the same rate as sales.

● Interest costs are expected to remain unchanged.

● The tax rate is expected to remain at 40%. On the basis of that information, what will be the forecast
for Roberts’ year-end net income? $156M

17-8 LONG-TERM FINANCING NEEDED At year-end 2018, total assets for Arrington Inc. were $1.8
million and accounts payable were $450,000. Sales, which in 2018 were $3.0 million, are expected to
increase by 25% in 2019. Total assets and accounts payable are proportional to sales, and that
relationship will be maintained; that is, they will grow at the same rate as sales. Arrington typically uses
no current liabilities other than accounts payable. Common stock amounted to $500,000 in 2018, and
retained earnings were $475,000. Arrington plans to sell new common stock in the amount of $130,000.
The firm’s profit margin on sales is 5%; 35% of earnings will be retained.

a. What were Arrington’s total liabilities in 2018? 825,000

b. How much new long-term debt financing will be needed in 2019? (Hint: AFN 2 New stock 5 New long-
term debt.) 141,875

17-9 SALES INCREASE Paladin Furnishings generated $4 million in sales during 2018, and its year-end
total assets were $3.2 million. Also, at year-end 2018, current liabilities were $500,000, consisting of
$200,000 of notes payable, $200,000 of accounts payable, and $100,000 of accrued liabilities. Looking
ahead to 2019, the company estimates that its assets must increase by $0.80 for every $1.00 increase in
sales. Paladin’s profit margin is 3%, and its retention ratio is 50%. How large of a sales increase can the
company achieve without having to raise funds externally? 84,507
17-10 REGRESSION AND RECEIVABLES Edwards Industries has $320 million in sales. The company
expects that its sales will increase 12% this year. Edwards’ CFO uses a simple linear regression to
forecast the company’s receivables level for a given level of projected sales. On the basis of recent
history, the estimated relationship between receivables and sales (in millions of dollars) is as follows:

Receivables 5 $9.25 1 0.07(Sales)

Given the estimated sales forecast and the estimated relationship between receivables and sales, what
are your forecasts of the company’s year-end balance for receivables and its year-end days sales
outstanding (DSO) ratio? Assume that DSO is calculated on the basis of a 365-day year.

$34.338 million
34.97 ≈ 35 days

17-11 REGRESSION AND INVENTORIES Charlie’s Cycles Inc. has $110 million in sales. The company
expects that its sales will increase 5% this year. Charlie’s CFO uses a simple linear regression to forecast
the company’s inventory level for a given level of projected sales On the basis of recent history, the
estimated relationship between inventories and sales (in millions of dollars) is as follows:

Inventories = $9 1 0.0875(Sales)

Given the estimated sales forecast and the estimated relationship between inventories and sales, what
are your forecasts of the company’s year-end inventory level and its inventory turnover ratio?
Sales - 110M x (1.05) = 115.5M
Inventory - 9 + 0.0875(115.5) = 19,106,250
Sales/Inventory - 115.5M/19.10625M = 6.0451 x

17-12 EXCESS CAPACITY Earleton Manufacturing Company has $3 billion in sales and $787,500,000 in
fixed assets. Currently, the company’s fixed assets are operating at 80% of capacity.

a. What level of sales could Earleton have obtained if it had been operating at full capacity? $3.75
BILLION

b. What is Earleton’s target fixed assets/sales ratio? The company's target fixed assets or sales ratio
is 21%.

c. If Earleton’s sales increase 30%, how large of an increase in fixed assets will the company need to
meet its target fixed assets/sales ratio? The company needs to increase $31,500,000 of its FA in
order to meet their target fixed assets / sales ratio.
17-13 ADDITIONAL FUNDS NEEDED Morrissey Technologies Inc.’s 2018 financial statements are shown
here

Suppose that in 2019, sales increase by 10% over 2018 sales. The firm currently has 100,000 shares
outstanding. It expects to maintain its 2018 dividend payout ratio and believes that its assets should
grow at the same rate as sales. The firm has no excess capacity. However, the firm would like to reduce
its operating costs/sales ratio to 87.5% and increase its total liabilities-to assets ratio to 30%. (It believes
its liabilities-to-assets ratio currently is too low relative to the industry average.) The firm will raise 30%
of the 2019 forecasted interest-bearing debt as notes payable, and it will issue long-term bonds for the
remainder. The firm forecasts that its before-tax cost of debt (which includes both short- and long-term
debt) is 12.5%. Assume that any common stock issuances or repurchases can be made at the firm’s
current stock price of $45.

a. Construct the forecasted financial statements assuming that these changes are made. What are the
firm’s forecasted notes payable and long-term debt balances? NP = 89, 100, LTD= 207, 900 What is the
forecasted addition to retained earnings? 109, 890
b. If the profit margin remains at 5% and the dividend payout ratio remains at 60%, at what growth rate
in sales will the additional financing requirements be exactly zero? In other words, what is the firm’s
sustainable growth rate? (Hint: Set AFN equal to zero and solve for g.) 3.45%

17-14 EXCESS CAPACITY Krogh Lumber’s 2018 financial statements are shown here.

a. Assume that the company was operating at full capacity in 2018 with regard to all items except fixed
assets; fixed assets in 2018 were being utilized to only 75% of capacity. By what percentage could 2019
sales increase over 2018 sales without the need for an increase in fixed assets? 33.33%

b. Now suppose 2019 sales increase by 25% over 2018 sales. Assume that Krogh cannot sell any fixed
assets. All assets other than fixed assets will grow at the same rate as sales; however, after reviewing
industry averages, the firm would like to reduce its operating costs/sales ratio to 82% and increase its
total liabilities-toassets ratio to 42%. The firm will maintain its 60% dividend payout ratio, and it
currently has 1 million shares outstanding. The firm plans to raise 35% of its 2019 forecasted interest-
bearing debt as notes payable, and it will issue bonds for the remainder. The firm forecasts that its
before-tax cost of debt (which includes both short- and long-term debt) is 11%. Any stock issuances or
repurchases will be made at the firm’s current stock price of $40. Develop Krogh’s projected financial
statements like those shown in Table 17.2. What are the balances of notes payable, bonds, common
stock, and retained earnings?

NP = 3,553.20
Bonds = 6598.80
CS = 2,514.01
RE = 28,283.99

COST OF CAPITAL

When calculating the WACC, our concern is with capital that must be provided by investors—interest-
bearing debt, preferred stock, and common equity.

Accounts payable and accruals, which arise spontaneously when capital budgeting projects are
undertaken, are not included as part of investor-supplied capital because they do not come directly from
investors.

Target Capital Structure The mix of debt, preferred stock, and common equity the firm plans to raise to
fund its future projects.

Capital Components One of the types of capital used by firms to raise funds

 rd = interest rate on the firm’s new debt 5 before-tax component cost of debt. It can be found in
several ways, including calculating the yield to maturity on the firm’s currently outstanding
bonds
 rd(1 - T) = after-tax component cost of debt, where T is the firm’s marginal tax rate. rd (12T) is
the debt cost used to calculate the weighted average cost of capital. As we shall see, the after-
tax cost of debt is lower than its before-tax cost because interest is tax deductible.
 rp = component cost of preferred stock, found as the yield investors expect to earn on the
preferred stock. Preferred dividends are not tax deductible; hence, the before- and after-tax
costs of preferred are equal.
 rs = component cost of common equity raised by retaining earnings, or internal equity. It is the
rs developed in Chapters 8 and 9 and defined there as the rate of return that investors require
on a firm’s common stock. Most firms, once they have become well established, obtain all of
their new equity as retained earnings; hence, rs is their cost of all new equity.
 re = component cost of external equity, or common equity raised by issuing new stock. As we
will see, re is equal to rs plus a factor that reflects the cost of issuing new stock. Note, though,
that established firms such as Allied Food rarely issue new stock; hence, re is rarely a relevant
consideration except for very young, rapidly growing firms.
 wd, wp, wc = target weights of debt, preferred stock, and common equity (which includes
retained earnings, internal equity, and new common stock, external equity). The weights are the
 percentages of the different types of capital the firm plans to use when it raises capital in the
future. Target weights may differ from actual current weights.5 WACC 5 the firm’s weighted
average, or overall, cost of capital

Weighted Average Cost of Capital (WACC) A weighted average of the component costs of debt,
preferred stock, and common equity.

Cost of Debt, rd(1-T)

Before-Tax Cost of Debt, rd The interest rate the firm must pay on new debt

After-Tax Cost of Debt, rd(1-T) The relevant cost of new debt, taking into account the tax deductibility
of interest; used to calculate the WACC


 The interest rate a firm must pay on its new debt is defined as its before-tax cost of debt, rd.
Firms can estimate rd by asking their bankers what it will cost to borrow or by finding the
yield to maturity on their currently outstanding debt (as we illustrated in Chapter 7).
However, the after-tax cost of debt, rd(1-T), should be used to calculate the weighted
average cost of capital.

It is important to emphasize that the cost of debt is the interest rate on new debt, not outstanding debt.
We are interested in the cost of new debt because our primary concern with the cost of capital is its use
in capital budgeting decisions.

Cost of Preferred Stock, rp

Cost of Preferred Stock, rp The rate of return investors require on the firm’s preferred stock; rp is
calculated as the preferred dividend, Dp , divided by the current price, Pp

Cost of Retained Earnings, rs

Cost of Retained Earnings, rs The rate of return required by stockholders on a firm’s common stock.

Cost of New Common Stock, re The cost of external equity; based on the cost of retained earnings, but
increased for flotation costs necessary to issue new common stock
10-5A CAPM APPROACH The most widely used method for estimating the cost of common equity is the
capital asset pricing model (CAPM) as developed in Chapter 8.12 Here are the steps used to find rs :

Step 1: Estimate the risk-free rate, rRF. We generally use the 10-year Treasury bond rate as the measure
of the risk-free rate, but some analysts use the shortterm Treasury bill rate.

Step 2: Estimate the stock’s beta coefficient, bi , and use it as an index of the stock’s risk. The i signifies
the ith company’s beta.

Step 3: Estimate the market risk premium. Recall that the market risk premium is the difference
between the return that investors require on an average stock and the risk-free rate.

Step 4: Substitute the preceding values in the CAPM equation to estimate the required rate of return on
the stock in question:

10-5B BOND-YIELD-PLUS-RISK-PREMIUM APPROACH In situations where reliable inputs for the CAPM
approach are not available, as would be true for a closely held company, analysts often use a somewhat
subjective procedure to estimate the cost of equity. Empirical studies suggest that the risk premium on a
firm’s stock over its own bonds generally ranges from 3 to 5 percentage points.14 Based on this
evidence, one might simply add a judgmental risk premium of 3% to 5% to the interest rate on the firm’s
own long-term debt to estimate its cost of equity. Firms with risky, low-rated, and consequently
highinterest-rate debt also have risky, high-cost equity, and the procedure of basing the cost of equity
on the firm’s own readily observable debt cost utilizes this logic. For example, given that Allied’s bonds
yield 10%, its cost of equity might be estimated as follows:

rs = Bond yield + Risk premium